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April 21, 2020
Hedge Fund Investing through a Pandemic
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Hedge Fund Investing through a Pandemic

Hedge Fund Investing through a Pandemic

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April 21, 2020

 
 

The first quarter of 2020 was defined by the rise of the novel coronavirus pandemic and its impact on global markets and economies.

 
 

Markets have moved with a magnitude and velocity that rivals aspects of the 1987 Crash, the sudden stop of certain industries following the terrorist attacks of September 11, 2001 (9/11), and the severity of the Great Financial Crisis (GFC). Volatility levels reached historic highs in March, with substantial moves across all asset classes (Display 1). 

 
 

Display 1: Asset Class Performance during the Quarter

Click-through performance chart below

Source: Bloomberg as of April 1, 2020. Past performance is not a guarantee of future results.

 
 

While hedge funds generally mitigated downside risk well, results varied depending on direct equity beta or structured credit exposure (Display 2). In fact, dispersion was the highest observed since October 2008. 

 
 
 
Display 2: Hedge Fund Industry Returns During the Quarter
 

Source: Hedge Fund Research, Inc., as of April 15, 2020. Past performance is not a guarantee of future results.

 
 

Macro strategies performed best during the quarter, mitigating downside risk and delivering a positive return. While there was considerable dispersion within the group, more liquid and developed-market-focused discretionary strategies generally delivered strong performance. Managers positioned with risk-off biases and highly convex, long volatility strategies were among the most notable performers. Discretionary commodity strategies also performed well.   Top-performing managers benefited significantly from long positions in fixed income, particularly the front-end of the U.S. yield curve, gold and volatility products as well as short exposure to equities and crude oil. These gains were tempered by managers with outsized exposure to emerging markets, where there was broad-based weakness across asset classes. Specific detractors included long positions in Argentine sovereign credit, Brazilian equities, and Mexican and Russian interest rates.

Relative-value strategies held up comparatively well during the chaotic quarter. Long volatility-oriented strategies benefited from the unprecedented rise in realized volatility, while credit products suffered because of lack of liquidity and widening spreads. However, sovereign fixed income relative-value strategies took advantage of the preference for liquid Treasury futures contracts during the large rally in Treasuries, and many profited as funding stresses abated. 

Structured credit performance was meaningfully negative as all sectors were exposed to the March market selloff to varying degrees. A confluence of events in mid-March triggered a liquidity vortex, where record outflows from fixed income funds, prime money markets funds and levered exchange-traded funds (ETFs) triggered an initial round of selling. Daily liquidity funds aggressively sold high-quality and more liquid bonds to meet redemptions, leading to accelerated price declines and margin calls. In addition to a technical dislocation, the fundamentals for credit-sensitive lenders quickly deteriorated because of severe economic disruption to homeowners’ and commercial real estate tenants’ ability to pay rents and mortgages. Selling intensified as haircuts and general collateral repo rates increased for levered players, including mortgage real estate investment trusts (REITs) and hedge funds.

To prevent the market from seizing, the Federal Reserve (the Fed) cut short-term rates, opened swap lines to help U.S. dollar-funding demands, and initiated several facilities to stabilize money market, commercial paper, and primary and secondary corporate credit markets. The Fed also restarted an asset purchase program, including U.S. Treasury and agency mortgage-backed securities. However, nonagency residential mortgage-backed securities and commercial mortgage-backed securities were not direct beneficiaries of the Fed’s support, which wreaked havoc on many mortgage arbitrage managers and reduced the effectiveness of their hedging strategies.

Amid the global market sell-off, equity long-short strategies generally struggled, some recouping steep losses during the powerful quarter-end rally. In aggregate, the group was hurt by underestimating the initial COVID-19 impact, outright beta exposure, de-risking during mid-March and uneven factor management. In general, technology and health care sector-focused managers fared well, and longer-biased energy-focused strategies lagged. On the whole, quantitative equity managers also underperformed. The degree of exposure to low volatility and value factors largely explains the dispersion of results seen across the peer group.

As a group, event-driven was hardest hit during the quarter, as reorganization equity holdings plunged and merger arbitrage spreads widened. Many distressed managers held concentrated positions in the devastated energy sector, and previously high-yielding opportunities in the retail, hotel and gaming industries underwent another round of severe re-rating. Within the category, credit arbitrage strategies were among the worst performers, particularly those in the lowest rating cohorts, amid a punishing environment for strategies driven by credit spreads and leverage. The damage to high-yield leveraged loans and commercial-focused real estate credit was extreme and will take some time to completely recover. 

Looking Ahead—Where Are the Risks and Where Are the Opportunities?

Living through an unprecedented demand-shock crisis serves as a tremendous learning opportunity. Given the magnitude of economic destruction and potential for long-lasting behavioral shifts, we think it is important to recognize this as an incident that does not lend itself to easy comparison with prior historical crises. While 9/11 resulted in a sudden stop of certain industries, as we are witnessing today, it was quite narrowly focused and there was an almost immediate return to normalcy. And though the magnitude of market losses is more similar to that experienced during the GFC, this is not a banking crisis affecting Main Street. Rather, it is an omnipresent health crisis affecting many aspects of commerce and human behavior.

The COVID-19 crisis is a first-order effect that is driving great uncertainty about the timing of an economic restart. In our view, the magnitude of lost economic productivity, the degree of permanent change and the likelihood of returning to normalcy are proportional to the time spent operating without a viable vaccine. Unfortunately, we think a simple V-shaped recovery scenario—after any initial surge in economic activity from pent-up demand—is oversimplifying the impact. We expect the pandemic will end up being a huge catalyst in driving a creative destruction process. Business models and broad industry groups will be impacted by accelerating Schumpeterian dynamics, with progress unduly influenced by ultra-accommodative central bank policies.  

A wide range of outcomes coupled with a supply shock from an ongoing oil price war between Russia and Saudi Arabia will sustain a regime of elevated volatility. Potential outcomes include reasonable odds of further capital market weakness and volatility expansion going forward. And we foresee more sustained intra-sector dispersion driven by second- and third-order impacts from these fluid undercurrents.

When correlations break down and large price declines occur, as they did in March, investors should look at how to best capitalize on opportunities stemming from the dislocation through a lens of certainty with respect to risk/reward and urgency. For example, many dislocated markets have already started functioning better because of central bank and government support, causing arbitrage-like opportunities to fade quickly. Thus, we believe it is important to be able to take a phased approach to hedge fund investing, adjusting implementation speed as situation-specific clarity evolves.   

Our Views on Hedge Fund Strategies

  • Macro
    Assuming continued heightened volatility levels across asset classes, we are very optimistic about the opportunity set for macro strategies. We are particularly sanguine about strategies with a liquid tactical orientation and those that leverage structuring expertise, exploiting embedded inefficiencies within more complex instruments. Discretionary global macro strategies have the potential to deliver positive results in stressed markets, as many did in Q1, as well as to profit when developed markets recover. In the latter case, debt demutualization, accelerating inflation dynamics and trends in government-supported industries could be particularly relevant investment themes.

    Over the next several years, several emerging markets (EMs) have substantial opportunity for significant economic and policy improvement. However, broader negative foreign direct investments and EM flows, low commodity prices and overtaxed health care systems may overwhelm their near-term prospects. EM re-rating opportunities are rarely available, except in less liquid, hard-to-hedge long-only formats, where long-duration equity and credit risk would have to be tolerated as successful policy and lasting economic factors take hold.

    To offset these risks as well as other betas, direct risk mitigation and other convex strategies could be appealing. While these strategies can have a negative expected return because of theta decay and high premiums, they can provide large positive payoffs in periods of stress, making costly unwinds in other parts of a portfolio unnecessary.   

  • Long-Short Equity
    We expect a substantial increase in dispersion and volatility that should benefit stock selection, especially in sectors subject to many cross-currents. Going forward, we believe that sector specialists with factor-attuned trading acumen will be rewarded as second- and third-order cross-currents impact stocks. We foresee large changes in global supply-chain dynamics, inventory management and stockpiling behaviors having the potential for radical impact on businesses.  Changes in consumer behavior and employer hiring practices will affect consumer confidence and spending but also service models and preferences. Furthermore, fluid government support for various industries, changing geopolitical trade priorities and evolving national-interest agendas will likely fuel the winner-and-loser struggle.

  • Credit
    We foresee a substantial expansion in the opportunity set for credit strategies, particularly in the higher-quality cohorts and with managers that have large cash balances and limited legacy issues. The Fed has removed most of the return potential from credit risk-remote securities, so investors will need to assume some form of credit risk or opt out of participating. While many hard-hit distressed and commercial real estate areas may be extremely mispriced, we believe investors should be wary of the longer duration commitments and the extensive supply of troubled assets.  

  • Systematic Macro
    We have a fairly positive view on shorter-term systematic strategies where heightened volatility, dispersion and investor impatience can be exploited through quantitative equity, statistical arbitrage and machine-learning models. We believe medium-term trend-following strategies could benefit from an environment in which price trends are likely to be sustained because of economic uncertainty. We are less constructive on systematic fundamental strategies, which rely on integrating historical fundamental economic data and the stability of past correlations.  Heightened central bank influence on market pricing may lower confidence in historical relationships and prove challenging for these types of strategies. Ultimately, as new patterns emerge in countries and regions, fundamentally-oriented strategies seeking alpha opportunities between asset classes, countries and markets should improve.  
     

Conclusion

These extraordinary times present investors with extraordinary opportunities and equally large risks. We believe that hedge funds represent the most unconstrained form of active management and are uniquely well positioned to deliver compelling and differentiated sources of return. The key, in our view, is being able to identify and capitalize on the right opportunities at the right time. As we look forward, we remain cautious, but laser-focused and very optimistic about the opportunities that lie ahead.

Index Descriptions

While the HFRI Indexes are frequently used, they have limitations (some of which are typical of other widely used indexes). These limitations include survivorship bias (the returns of the indexes may not be representative of all the hedge funds in the universe because of the tendency of lower-performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indexes, and the index may omit funds, the inclusion of which might significantly affect the performance shown). The HFRI Indexes are based on information self-reported by hedge fund managers who decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, LLC. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indexes may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways.

Hedge Fund Research, Inc. (HFRI) Fund Weighted Composite Index: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to the HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars, and have a minimum of $50 million assets under management or a 12-month track record.

Hedge Fund Research, Inc. (HFRI) Macro Index: The HFRI Macro Index consists of investment managers who trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, including both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods. Although some strategies employ RV techniques, macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact that movements in underlying macroeconomic variables may have on security prices, as opposed to equity hedge (EH), in which the fundamental characteristics of the company are integral to investment thesis, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios.

Hedge Fund Research, Inc. (HFRI) Equity Hedge Index (long/short equity): The HFRI Equity Hedge Index consists of managers who maintain positions both long and short in primarily equity and equity-derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors, and can range broadly in terms of levels of net exposure and leverage employed.

Hedge Fund Research, Inc. (HFRI) Event Driven Index: The HFRI Event Driven Index consists of investment managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety, including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event-driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company-specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

Hedge Fund Research, Inc. (HFRI) Relative Value Index: The HFRI Relative Value Index consists of investment managers who maintain positions where the investment thesis is predicated on the realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types.

NYMEX (New York Mercantile Exchange) Heating Oil Futures Index:

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing.

 
christopher.morser
Managing Director
AIP Hedge Fund Team
 
 
 
 

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The views expressed herein are solely those of the AIP Hedge Fund Team (the “Investment Team”) and are subject to change at any time due to changes in market and economic conditions. The views and opinions expressed herein are based on matters as they exist as of the date of preparation of this piece and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof. The data used has been obtained from sources generally believed to be reliable. No representation or warranty is made as to its accuracy, completeness, fairness or suitability.

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